And you know what makes personal finance so much fun for me? To say it’s personal is an understatement. Despite the fact that certain fundamental ideas are applicable to everyone, you have the freedom to customise them to match your own financial position. A good example of this is the implementation of a budget in personal financial management. My financial journey has progressed to the point where I no longer require a budget. I don’t keep track of my savings rate in the same way. Instead, I monitor my return on investment. First, we need to clarify the distinction between investing & saving in order to understand this.
Investing vs. Keeping money
People always use the terms “saving” and “investing” interchangeably in the context of personal finance. However, in practise, they imply quite distinct ideas. Savings to me entails setting money away for immediate needs. establishing an emergency fund and sometimes even saving for such a future expense are examples of this (i.e. car, vacation). My definition of a short-term aim is anything less than five years.
Investing, on either hand, I see as a long-term strategy for saving money. Funding your pension or your child’s college tuition are just two examples of this type of savings. In my mind, long-term goals are those that can be achieved in at least ten years’ time.
Even if the distinction appears to be nitpicky, I believe it is critical to remember. You may be able to take more risk with your money if you have a specific time frame for your goal. Which financial instruments you utilise for your money will be determined with how much danger you are willing to take. There are a number of low-risk options that you can utilise for short-term goals, including savings accounts, CD’s, and money markets. Preserving your capital is more important than maximising your return on investment. Long-term goals, on the other hand, allow you to take more of a chance. Stocks, mutual funds, as well as index funds, among other investment options, have the potential to provide investors with higher rates of return and capital growth over the course of time. In addition, the good long time horizon allows you to recover any losses that you incur during the course of the journey.
Rate of Savings
Your rate of return is just the amount of money you didn’t spend divided by the amount of money you made. Calculating your savings rate is similar to figuring out your net worth because there are numerous approaches. Using after-tax wages and pre-tax savings, I’ll do the math for this article. Let’s look at Mr. John Doe like a case study. $3,000 a month is his take-home earnings after taxes. His company’s 401(k) allows him to make pre-tax contributions of up to $500 every month. According to our assumption, this is his month-to-month spending plan:
Monthly, John Doe manages to save $500.
The savings after taxes are $500 each month, as you can see. His savings rate would be as follows, if I were to do the math.
Add up all the savings. ($500) minus ($500) is equal to ($1,000).
A pre-tax savings of 500 dollars can be added back to the take-home pay. An after-tax income of $3,000 plus $500 is $2,500.
The savings rate is calculated as follows: $1,000 minus $3,500, which equals a savings rate of 29 percent.
As of January 2017, the average net rate in the United States was 5.5 percent. A 29 percent savings rate, on the other hand, is impressive. It’s worth noting that some of Mr. Doe’s savings are set aside for future purchases. Even if this money will aid him in the near term, it will do little for his long-term objectives.
Determine the Investment Rate
Calculating who he’s investing is another way of looking at things. We can break down Mr. Doe’s savings into the following categories:
- Instead of a savings rate, an investment rate.
- After taxes, he’s only putting aside 40% ($200) of all money for the future. Money that is “investing” and money that is “saving” are two ways to look at Mr. Doe’s investment rate.
- Make a tally of all of your investments. 401(k): $500; Roth IRA: $200; Total: $700
Maintain the same post-tax earnings. $3,500
Total investments divided by post-tax earnings: $700 / $3,500 = 0.2 / 20%.
Even if it’s still above average when compared to the national average, his personal savings rate has dropped by over a third. Let’s say Mr. Doe decides to save his $200 instead of investing it in a Roth IRA. He’d keep his savings rate at 29%, but his investment rate would drop to just 14% ($500/$3,500).
For Me, Tracking My Investment Rate Is a Helpful Tool
My financial situation is a little iffy. It’s complicated since I have to save money for both quarterly and annual tax estimates. In the classic way, should I have to include a money in the computation of my savings rate? Is it okay if I deduct it from my taxable income and keep the remainder as my take-home pay? Is it better to wait until I filed our tax return and do a back calculation to see what my savings rate will be? My head can’t keep up with all the questions and scenarios. As a result, I simply divide the amount I put into the business by the salary I receive. Using this strategy, my 2016 investment rate was 26%. There’s space for improvement, but it’s not horrible. In 2017, we’ll have to wait and see…
What actually works for you is the best choice.
Always go with what work for you, no matter what anyone else tells you to do. Using a more traditional method of tracking your contribution rate (i.e. money saved against money earned) is OK if it works for your financial circumstances and goals. In other words, the goal is that you’re spending less because you make. My personal preference is to monitor my investment pace. My long-term goals, such as saving for retirement, are more accurately assessed thanks to this tool.